The need to be out of cash and invested in certain assets could not be more palpable. House prices and stock markets are appreciating and looming concerns of inflation ride high as gold and precious metals continue to hold their luster. Yet with the exception of the certain real estate markets, the underlying prices of many assets are not terribly enticing.
Howard Marks wrote an excellent piece crucifying bonds in favor of equities. For someone to invest in bonds they must feel very strongly about a deflationary environment as an increase in inflation decimates the return of a fixed-rate bond. Marks still cautions against equities even though he describes them as being much more attractive relative to bonds. To paraphrase some of his points, as stock market valuations rise much faster than underlying earnings then you must expect either a) continued high growth in earnings in the future or b) diminished future returns in stocks.
So why should you hold cash?
Cash has a couple benefits relative to other securities. Cash becomes more valuable when the markets go awry. For example, say inflation expectations suddenly change. Clearly the market expects inflation to remain subdued as rates in the bond market are still quite low. But suppose the economy gains steam and the investors expect a 5% inflation going forward. The bond market would likely convulse and bond prices would tumble. At that moment the dollars in your checking account would buy more in bonds even though they would buy fewer goods in the future should inflation actually poke its head. Bonds are inextricably linked to inflation and a rise in inflation drives the prices of bonds down.
Contrary to comments by Warren Buffett, there is a small penalty to not swinging in investing. The cash that sits un-invested will depreciate at the rate of inflation and currently it is doing so at 2%. But even if your money does depreciate at such manageable amounts you can still count on stock market volatility in the future. If history is a guide there will be plenty more opportunities to buy stocks when prices are undeniably cheap.
I wouldn’t advocate holding your whole portfolio in cash, but having cash on hand is certainly a good thing. In Alice Schroeder’s biography of Warren Buffett she describes his attitude towards cash: “This is one of the most important things I learned from him: the optionality of cash. He thinks of cash as a call option with no expiration date, an option on every asset class, with no strike price. It is a pretty fundamental insight. Because once an investor looks at cash as an option – in essence, the price of being able to scoop up a bargain when it becomes available – it is less tempting to be bothered by the fact that in the short term, it earns almost nothing.”
If stocks and other investments continue to grow pricier relative to earnings, then it would be wise to hold increasing amounts of cash. It’s at these moments when cash becomes the contrarian investment. Howard Marks wrote in his article that the stock market’s current P/E ratio of 16 is at the historical average for post-World War II (very interesting he decided to leave out the '30s, as that would certainly bring the average down). In any case, being that we are dealing with averages, we can expect some below-average P/E ratios sometime in the future.
Also check out:
- Warren Buffett Undervalued Stocks
- Warren Buffett Top Growth Companies
- Warren Buffett High Yield stocks, and
- Stocks that Warren Buffett keeps buying
- Howard Marks Undervalued Stocks
- Howard Marks Top Growth Companies
- Howard Marks High Yield stocks, and
- Stocks that Howard Marks keeps buying